Chapter 11

The Cost of Capital

The Firms Capital Structure

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Some Key Assumptions

Business Riskthe risk to the firm of being unable to cover operating costsis assumed to be unchanged. This means that the acceptance of a given project does not affect the firms ability to meet operating costs. Financial Riskthe risk to the firm of being unable to cover required financial obligationsis assumed to be unchanged. This means that the projects are financed in such a way that the firms ability to meet financing costs is unchanged. After-tax costs are considered relevantthe cost of capital is measured on an after-tax basis.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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Specific Sources of Capital: The Cost of Long-Term Debt

The pretax cost of debt is equal to the the yield-tomaturity on the firms debt adjusted for flotation costs. Recall that a bonds yield-to-maturity depends upon a number of factors including the bonds coupon rate, maturity date, par value, current market conditions, and selling price. After obtaining the bonds yield, a simple adjustment must be made to account for the fact that interest is a tax-deductible expense. This will have the effect of reducing the cost of debt.
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Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Specific Sources of Capital: The Cost of Long-Term Debt (cont.)

Net Proceeds
Duchess Corporation, a major hardware manufacturer, is

contemplating selling $10 million worth of 20-year, 9% coupon

bonds with a par value of $1,000. Because current market interest rates are greater than 9%, the firm must sell the bonds at $980. Flotation costs are 2% or $20. The net proceeds to the firm for each bond is therefore $960 ($980 - $20).

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Specific Sources of Capital: The Cost of Long-Term Debt (cont.)

Before-Tax Cost of Debt
Approximating the Cost

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Specific Sources of Capital: The Cost of Long-Term Debt (cont.)

Find the after-tax cost of debt for Duchess assuming it has a 40% tax rate:
ki = 9.4% (1-.40) = 5.6%

This suggests that the after-tax cost of raising debt capital for Duchess is 5.6%.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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Specific Sources of Capital: The Cost of Preferred Stock

Duchess Corporation is contemplating the issuance of a 10% preferred stock that is expected to sell for its $87-per share value. The cost of issuing and selling the stock is expected to be $5 per share

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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Specific Sources of Capital: The Cost of Preferred Stock

Duchess Corporation is contemplating the issuance of a 10% preferred stock that is expected to sell for its $87-per share value. The cost of issuing and selling the stock is expected to be $5 per share. The dividend is $8.70 (10% x $87). The net proceeds price (Np) is $82 ($87 - $5). KP = DP/Np = $8.70/$82 = 10.6%
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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Specific Sources of Capital: The Cost of Common Stock

There are two forms of common stock financing: retained earnings and new issues of common stock. In addition, there are two different ways to estimate the cost of common equity: any form of the dividend valuation model, and the capital asset pricing model (CAPM). The dividend valuation models are based on the premise that the value of a share of stock is based on the present value of all future dividends.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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Specific Sources of Capital: The Cost of Common Stock (cont.)

Using the constant growth model, we have:
kS = (D1/P0) + g

We can also estimate the cost of common equity using the CAPM:
kE = rF + b(kM - RF).

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Specific Sources of Capital: The Cost of Common Stock (cont.)

Cost of Retained Earnings (kE)
Constant Dividend Growth Model
ks = D1/P0 + g

For example, assume a firm has just paid a dividend of $2.50 per share, expects dividends to grow at 10% indefinitely, and is currently selling for $50.00 per share. First, D1 = $2.50(1+.10) = $2.75, and
kS = ($2.75/$50.00) + .10 = 15.5%.
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Specific Sources of Capital: The Cost of Common Stock (cont.)

Cost of Retained Earnings (kE)
Security Market Line Approach
ks = rF + b(kM - RF). For example, if the 3-month T-bill rate is currently 5.0%, the market risk premium is 9%, and the firms beta is

1.20, the firms cost of retained earnings will be:

ks = 5.0% + 1.2 (9.0%) = 15.8%.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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Specific Sources of Capital: The Cost of Common Stock (cont.)

Cost of New Equity (kn)
Constant Dividend Growth Model
kn = = D1/Nn - g Continuing with the previous example, how much would it cost the firm to raise new equity if flotation costs amount

to $4.00 per share?

kn = [$2.75/($50.00 - $4.00)] + .10 = 15.97% or 16%.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights
The weights in the above equation are intended to represent a specific financing mix (where wi = % of debt, wp = % of preferred, and ws= % of common). Specifically, these weights are the target percentages of debt and equity that will minimize the firms overall cost of raising funds.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights
One method uses book values from the firms balance sheet. For example, to estimate the weight for debt, simply divide the book value of the firms long-term debt by the book value of its total assets.

To estimate the weight for equity, simply divide the total

book value of equity by the book value of total assets.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights
A second method uses the market values of the firms debt and equity. To find the market value proportion of debt, simply multiply the price of the firms bonds by the number outstanding. This is equal to the total market value of the firms debt. Next, perform the same computation for the firms equity by multiplying the price per share by the total number of shares outstanding.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights
Finally, add together the total market value of the firms equity to the total market value of the firms debt. This yields the total market value of the firms assets. To estimate the market value weights, simply dividend

the market value of either debt or equity by the market

value of the firms assets .
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights
For example, assume the market value of the firms debt is $40 million, the market value of the firms preferred stock is $10 million, and the market value of the firms equity is $50 million. Dividing each component by the total of $100 million gives us market value weights of 40% debt, 10% preferred, and 50% common.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

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The Weighted Average Cost of Capital

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights
Using the costs previously calculated along with the market value weights, we may calculate the weighted average cost of capital as follows: WACC = .40(5.67%) + .10(9.62%) + .50(15.8%) = 11.13% This assumes the firm has sufficient retained earnings to fund any anticipated investment projects.
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The Weighted Average Cost of Capital: Economic Value Added (EVA)

EVA is a popular measure used by firms to determine whether an investment contributes to owners wealth.

EVA can be calculated as the difference between Net Operating Profits After Taxes (NOPAT) and the cost of funds used to finance the investment.
The cost of funds is found by multiplying the dollar amount of funds used to finance the investment by the firms WACC.
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The Weighted Average Cost of Capital: Economic Value Added (EVA)

For Example, the EVA of an investment of $3.75 million by a firm with a WACC of 10% in a project expected to

generate NOPAT of $410,000 would be: EVA = $410,000 (10% x $3,750,000) = $35,000
Because the EVA is positive, the proposed investment is expected to increase owner wealth and is therefore acceptable.
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